Subprime: The risk to Wall Street

As subprime woes widen, the money machines at Morgan Stanley, Goldman and other banks may sputter.

NEW YORK (CNNMoney.com) -- Wall Street's big banks have been money-making machines, posting record earnings in recent years, but the shakeout in the subprime mortgage business threatens to derail their stellar run.

Subprime mortgages - home loans given to borrowers with weak credit - have been a lucrative business for investment banks, which buy the loans, repackage them and sell them to investors around the world, including pension funds and hedge funds.

But cracks in the subprime sector have been surfacing at an alarming speed. On Monday, No. 2 subprime lender New Century Financial (Charts) warned that it faces $8.4 billion in loan repayment obligations - little more than a week after revealing doubts about its ability to survive.

First, they lose if subprime lenders can't pay back the money they've borrowed from Wall Street to bankroll their mortgage business, said Gary Gordon, managing director of research at independent research firm Portales Partners.

Second, with the growing problems roiling subprime, there will be fewer of these mortgages issued for the banks to repackage and sell as securities to investors - an area that has become extremely lucrative for Wall Street.

How big a hit they take remains to be seen since they are so deeply involved in different parts of the subprime mortgage business, analysts said.

Lehman (Charts) and Bear Stearns (Charts) have been among the most aggressive in the business of buying subprime loans and repackaging them for sale to investors. Morgan Stanley and Merrill Lynch (Charts) have jumped even further into the business, by purchasing subprime mortgage lenders outright.

"The biggest risk lies not so much in the losses that they're going to absorb [from defaulted loans] but in the fact that mortgage bankers aren't going to originate as many loans," said Punk Ziegel analyst Dick Bove.

Overall, lenders in the subprime sector made some $640 billion in mortgage loans last year, about a fifth of the total mortgage market and nearly double the amount from 2003.

But Gordon from Portales Partners expects the size of the market to tumble this year and next. He estimated it could be closer to $300 billion by 2008.

Investors and analysts may get a better look at the risk subprime poses when earnings are reported. Goldman Sachs, Bear Stearns and Lehman are all due to announce quarterly results this week.

Bove from Punk Ziegel expects many firms will eventually have to absorb some losses from mortgage lenders who themselves have gotten hit by rising defaults by borrowers. But he doesn't think the losses will be big enough to significantly impact earnings.

Prashant Bhatia, a Citigroup analyst, echoed that view, saying in a research note issued Friday that "the marketplace is overreacting to brokerage subprime exposures."

Bhatia is forecasting strong quarterly results from Goldman, Morgan Stanley and Lehman and expects them to say that subprime exposure is minimal and isn't spilling over to other parts of their business.

But Josh Rosner, a managing director at research firm Graham-Fisher, warned that the problems in subprime could start to spread to other borrowers in the mortgage market - which means the pain for Wall Street may just be starting.

"It makes sense that problems would surface first among subprime borrowers -these are the most leveraged borrowers with the least financial wherewithal to stay current with payments. But we're going to see it spread [to other borrowers]," he said.